Saif al-Islam after his capture in Libya. Lord Woolf's inquiry is looking at the burgeoning commercial interests that lay behind Saif’s relationship with the LSE. Photograph: Reuters/Reuters

The Foreign Office lobbied Oxford university to accept Muammar Gaddafi's son Saif al-Islam as a student in the hope of encouraging a rapprochement with Libya, an inquiry has found.

An investigation by Lord Woolf, a former lord chief justice, has underlined the support shown by the British government and UK firms for the dictator's son as companies scented opportunities to do business with Libya.

The inquiry was set up to investigate the London School of Economics' links with Libya, including a decision to accept a £1.5m donation from a charity run by Gaddafi's son to fund a north Africa research programme.

The inquiry finds a "disconcerting number of failures in communication and governance" in the LSE's relations with the Libyan regime. The scandal erupted as Libyans rose up against the Gaddafi regime and led to the resignation of director Sir Howard Davies.

But it also looks at the burgeoning commercial interests which lay behind Saif's relationship with the LSE. The inquiry reports that the arms firm BAE Systems sent an employee from its marketing team to work with Saif al-Islam.

This employee helped Saif's application to study at the LSE, where he was accepted in August 2002. The BAE employee was formally seconded to Saif's charity by BAE – which continued to pay the employee's salary – between 2004 and 2006.

BAE told the inquiry that at the time Libya was "seemingly coming into the fold" and the government was keen that British business should be poised to deal with the Gaddafi regime. BAE said it was not preparing to sell arms to Libya but meet civil requirements such as airport radar.

In the spring of 2002 a senior civil servant at the Foreign Office asked Oxford university if Saif could take a master's degree course. "It was made clear … that the FCO would appreciate help in this case since Libya was opening up to the West again." The head of Oxford's department of international development told the FCO that the application would be "unlikely to prosper … because Saif had no social science training, and his prior degree did not meet the requisite quality standard".

The FCO dropped its request, the inquiry was told.

The LSE donation was channelled through Saif's charity but its original source may have been three private firms. Woolf said he could not rule out that the money had been paid as bribes to Saif al-Islam.

According to an email from Saif's personal assistant, the original source of the donation were three companies – Turkish, Italian and Scottish – bidding for construction and engineering work in Libya.

The Scottish firm specialises in "seeking commercial opportunity in Libya, especially in the military sphere", according to an internal LSE note.

"Knowledge that the gift was being funded by private companies which carried out work in Libya ought to have raised red flags," the report says.

Saif is now in custody in Libya after being captured in the country's southern desert earlier this month.

The inquiry report says it was an LSE academic, Professor David Held, who "first approached Saif about the possibility of funding his centre for Global Governance in December 2008".

The gift offered was of £1.5m in tranches of £300,000 over five years. Periodic payments were to be made annually.

The report says: "This was not a one-off donation but the founding of a relationship between the school and the donor, which is not unusual. However, bearing in mind the volatility of the Gaddafi regime, the gift involved a substantial risk because of the length of the relationship."

A decision was made that the gift would not come from Saif directly but from "private sector sources".

This step "became essential to Held's presentation of the gift. Unless the money could be shown as coming to the foundation from private sources it could have been seen as unacceptable money from the Libyan state." Lord Woolf's report says that the "private aspect of this gift was particularly troublesome".

He writes: "I am not satisfied (and it could not have been demonstrated to council) that the money which was the source of the donation to the LSE from Saif's foundation was not the result of payments to influence Saif to look upon private companies with favour."

He quotes a former British ambassador to Libya saying that it was common knowledge that Saif was "deep into acting as an intermediary for major business interests in Libya". The donation was accepted despite internal protest. The inquiry noted a warning by Fred Halliday, a Middle East expert at the LSE, in 2009, that: "Persons without any deep knowledge of Libyan or Arab politics had attempted to persuade him that Libya was changing. However, in 2009 Libya remained one of the most dictatorial and opaque of Arab regimes."

Woolf said the LSE's director at the time, Sir Howard Davies, bore "responsibility for what went wrong".

Davies resigned in March after the university's reputation was battered by its links with Libya.

Held, professor of political science at the LSE, was an academic adviser to the toppled dictator's son when he studied at the London university and was director of the research programme funded by Saif al-Islam's charity.

Saif al-Islam was allowed to lay out "objectives and expectations" for the programme, according to leaked LSE documents.

Woolf writes: "I come to no conclusions as to whether there was or would have been excessive influence by the donor over the use of the funds from Saif's foundation. However, what has been made plain is that proper structures of governance are needed to protect academic integrity against influence from the interests of private donors."

Woolf's inquiry looked at a range of connections between the LSE and the Gaddafi regime, including:

• A £2.2m contract to train Libyan civil servants and professionals. £1.5m of this money was received.

• A payment of £20,000 for tuition of the head of the Libyan investment authority.

• A payment to the university of $50,000 after Davies gave advice to Libya's sovereign wealth fund in 2007.

• An award from Gaddafi's charity of £22,857 to cover travel costs for academic speakers to travel to Libya.

A separate inquiry has been conducted into allegations of plagiarism in Saif al-Islam's PhD thesis by the University of London, which awarded the degree. This has concluded that the PhD should not be revoked.

The Woolf inquiry said, however, that: "Saif's background meant he could procure a level of assistance which would not be open to the ordinary PhD student."

The North Africa Research Programme was suspended when the Libyan uprising began this year, while LSE Global Governance was closed at the end of July. The LSE has agreed to put £300,000 – equivalent to the cash it has received from the Gaddafi foundation to set up the research programme – into a scholarship for north African students.

The LSE has appointed a new director, the US sociologist Craig Calhoun, who starts next September.